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May 31, 2012

The US Fiscal and Generational Gap

Posted by Nicoletta Batini, IMF Senior Economist

The day-to-day functions of the U.S. federal government—from running national parks to sending out tax refunds—risked paralysis on April 8 as both chambers of Congress and the White House struggled to hammer out an elusive budget deal before funding run out on Friday, triggering a partial government shutdown.

Yet a partial government shutdown this spring may not be the biggest and hardest-to-fix fiscal headache awaiting the U.S. fiscal authorities. Looking beyond the next few years, the United States is facing a most challenging fiscal situation due to the perfect storm created by high fiscal deficits, an ageing population and rapid growth in government-provided healthcare benefits. IMF and Congressional Budget Office forecasts imply that by the end of this century a repayment of U.S. debt stock could absorb up to 10 times or more today’s entire yearly U.S. gross domestic product.

How large is the U.S. fiscal problem? Clearly the answer depends on many factors: the natural ageing of the US population; the evolution of the cost of medical care relative to the general level of prices and wages; the growth rate of the economy.

Taking the difference between all the United States owes and will owe in the future (mainly its debit deriving from commitments to pay pension benefits and healthcare for all eligible U.S. citizens from next year onwards) and all it will earn (from tax revenues etc.), and using demographic and economic assumptions in the CBO (2010) Long-Term Budget Outlook Alternative Scenario, the fiscal “gap” under a “current law” scenario is very large and corresponds to over 15 percent of the value of all future U.S. GDP in today’s dollar terms.[1]

Closing this gap requires drastic actions.

If one cares about future generations and wants to split the “pain” of the adjustment equally across different age groups, then one needs a permanent annual fiscal adjustment of 15 percent of GDP every year into the indefinite future starting next year. Take the years 2020 and 2050 as examples. Primary balance estimates for these years used in calculating the gap without any adjustment to close today’s gap stand at -2.8 and -9 ½ percent of GDP, respectively. Fixing the gap so that living Americans, their children and their grandchildren “suffer” the same would hence require for those two years alone running instead a primary surplus in 2020 of 12.2 percent of GDP and in 2050 of 5 ½ percent of GDP (-2.8 percent of GDP plus 15 percentage points of GDP, and -9 ½ percent of GDP plus 15 percentage points of GDP). Additional similar yearly fiscal adjustments would be needed for each other future year as well (in other words the U.S. fiscal outlook net of interests on the debt has to improve by 15 percentage points forever starting now). If we put this in tax and transfer terms, an intergenerationally fair approach of this kind is equivalent to raising all taxes and cutting all transfers immediately and permanently by 35 percent (compared to our baseline projections, thus implying that not only the unborn but also current junior and senior citizens will have to receive less when they get old). A delay in the adjustment makes it more costly.

If currently-living Americans play selfish, and leave the bill to future Americans (the unborn) the pill is sweeter for them but terribly bitter for those who will come. One often-predicated option in this case is to stabilize the U.S. public debt only over a “short” finite horizon, like 2034. Estimates by the CBO and the IMF show that this would require a fiscal adjustment of “only” around 5-6 percent, requiring a primary surplus of “only” 3 percent of GDP in 2020 and a primary balance in 2030). Delivering small adjustments like these in the near term to fully protect currently-living Americans from paying more in taxes or avoid a cut on their own transfers, however, implies much larger fiscal adjustments later as the debt is left to bulge in outer years post 2034.

Now the good news. The U.S. government has several “lower-pain” and rather generationally fair options to get out of this situation. Under a scenario in which the government succeeds by 2012 in repealing the 2001, 2003 and 2009 tax cuts; the Alternative Minimum Tax (AMT) ceases to be indexed to inflation from 2011; and that growth in Medicare spending per beneficiary is bounded at 1 percent above the per capita growth rate of U.S. output for the future beginning next year (while all other healthcare spending is successfully constrained to grow in line with per capita income), the fiscal “gap” drops to less than 4 percent of the present discounted value of GDP, and the fiscal inequality generated by today’s large deficits and demographic change would mostly disappear. And although the listed measures are examples, these calculations highlight the need for a broader tax and entitlements’ reform.

Curbing Medicare spending is not easy, but the debate last year ahead of the passing of the healthcare reform legislation made clear that more consumer-directed care and a more efficient way to deal with the provision of long-term care could go a long way in achieving large and quality-improving cost restraint. Repealing the tax cuts, unindexing the AMT or embarking in a more comprehensive tax reform may prove far more difficult, however.

Note: The posts on the IMF PFM Blog should not be reported as representing the views of the IMF. The views expressed are those of the authors and do not necessarily represent those of the IMF or IMF policy.